It’s been all the rage the past few years.
And with good reason… This new technology has literally reshaped the world energy market and put America back on the oil and natural gas map.
Of course, I am talking about the shale revolution. Many investors seem to be clamoring to own a piece of the next big shale play — at higher and higher prices.
But while investors are champing at the bit to get their hands on the next shale field, I am selling most of my holdings in this space. In fact, I’ve sold five oil and gas companies from the portfolio in my Scarcity & Real Wealth newsletter in the past few weeks so I can focus my money elsewhere.
Let me explain why…
There’s a lot of talk about the growth potential of shale-focused producers (which admittedly has been explosive), and little talk of the risks involved with growing costs and infrastructure issues in areas that have never been drilled before.
And then there is the issue of unproven decline curves. You see, wells have been tested, and companies have made assumptions about decline rates, which they use to assign reserves. However, given that these are new operating areas, the assumptions about decline rates could turn out to be optimistic.
And trust me… you don’t want to be holding the bag when a company has to write down its assets.
But the main reason I am worried about this sector is the lofty valuations of many domestic producers.
Consider Range Resources Corp. (NYSE:RRC). The company now trades at an enterprise value of $15.5 billion. And yet the after-tax value of its reserves at year-end 2012 was just $3.2 billion.
That’s one of the richest valuations I’ve seen among producers today. This is because Range Resources Corp. (NYSE:RRC) is the cornerstone player in one of the most loved shale plays in the United States right now: the Marcellus, which is located in the northeast area of the country.
Range Resources Corp. (NYSE:RRC) has done a great job building and developing its Marcellus acreage position. But the stock today is priced to absolute perfection. I have a hard time seeing how the company will justify this valuation.
And it’s the same story with a lot of producers in the shale space. People are just too excited about it. And that’s the real problem. In my mind, there is only one way to make money from energy and commodities…
Look for sectors people are not excited about. As Howard Marks, co-founder of Oaktree Capital Management and one of the richest men in America, put it in his 2011 book “The Most Important Thing: Uncommon Sense for the Thoughtful Investor,” look for companies that make people say, “Who would want to own that?”
You see, commodities like copper or silver are always needed but are cyclical. So by buying when they are “hated,” you ensure that you’ll be positioned to benefit when prices eventually go up — it just requires patience.